Thursday, April 12, 2007

Speaking of
supply-side economics and trickle-down, Robert Frank explains that
trickle-down theory, which says that higher taxes on the wealthy will reduce
incentives causing lower growth and hence lower employment and income generally,
"is supported neither by theory nor evidence." Thus, contrary to what its proponents argue, trickle-down theory does not provide a valid
objection to a more progressive tax code:

Providing universal coverage will be expensive. With the median wage,
adjusted for inflation, lower now than in 1980, most middle-class families
cannot afford additional taxes. In contrast, the top tenth of 1 percent of
earners today make about four times as much as in 1980, while those higher up
have enjoyed even larger gains. ... In short, top earners are where the money
is. Universal health coverage cannot happen unless they pay higher taxes.

Trickle-down theorists are quick to object that higher taxes would cause top
earners to work less and take fewer risks, thereby stifling economic growth. ...
On close examination, however, this claim is supported neither by economic
theory nor by empirical evidence.

The surface plausibility of trickle-down theory owes much to the fact that it
appears to follow from the ... belief that people respond to incentives. Because
higher taxes on top earners reduce the reward for effort, it seems reasonable
that they would induce people to work less... As every economics textbook makes
clear, however, a decline in after-tax wages also exerts a second, opposing
effect. By making people feel poorer, it provides them with an incentive to
recoup their income loss by working harder than before. Economic theory says
nothing about which of these offsetting effects may dominate.

If economic theory is unkind to trickle-down proponents, the lessons of
experience are downright brutal. If lower real wages induce people to work
shorter hours, then the opposite should be true when real wages increase.
According to trickle-down theory, then, the cumulative effect of the last
century’s sharp rise in real wages should have been a significant increase in
hours worked. In fact, however, the workweek is much shorter now than in 1900.

Trickle-down theory also predicts a positive correlation between inequality
and economic growth, the idea being that income disparities strengthen
motivation to get ahead. Yet ... researchers ... find a negative correlation. In
the decades immediately after World War II, for example, income inequality was
low by historical standards, yet growth rates in most industrial countries were
extremely high. In contrast, growth rates have been only about half as large in
the years since 1973, a period in which inequality has been steadily rising.

The same pattern has been observed in cross-national data. ... Again and
again, the observed pattern is the opposite of the one predicted by trickle-down
theory.

The trickle-down theorist’s view of the world ... bears little resemblance to
reality. In the 1950s, American executives earned far lower salaries and faced
substantially higher marginal tax rates... Yet most of them competed
energetically for higher rungs on the corporate ladder. The claim that slightly
higher tax rates would cause today’s executives to abandon that quest is simply
not credible.

In the United States, trickle-down theory’s insistence that a more
progressive tax structure would compromise economic growth has long blocked
attempts to provide valued public services. Thus, although every other
industrial country provides universal health coverage, trickle-down theorists
insist that the wealthiest country on earth cannot afford to do so. Elizabeth
Edwards faces her battle with cancer with the full support of the world’s most
advanced medical system, yet millions of other Americans face similar battles
without even minimal access to that system.

Low- and middle-income families are not the only ones who have been harmed by
our inability to provide valued public services. For example, rich and poor
alike would benefit from an expansion of the Energy Department’s program to
secure stockpiles of nuclear materials that remain poorly guarded in the former
Soviet Union. Instead, the Bush administration has cut this program, even as
terrorists actively seek to acquire nuclear weaponry.

The rich are where the money is. Many top earners would willingly pay higher
taxes for public services that promise high value. Yet trickle-down theory,
which is supported neither by theory nor evidence, continues to stand in the
way. This theory is ripe for abandonment.

Here's a simple way to show that a an increase in taxes does not necessarily
reduce effort. Suppose you have a summer job and you have to earn $2,000 for the
summer. You don't need to earn any more than that, and don't plan to, but it is
a necessity that you reach this goal. Also suppose that you have a job paying
$10 per hour so that you can earn the money in 200 hours, or five 40 hour weeks. Let
taxes be zero initially.

Now let the government tax you at 50%, surely enough to reduce effort. But in
this case it won't. Instead, you will now work twice as long, 10 weeks or 400
hours at $5 per hour, in order to reach your goal of $2,000. So in this example,
a tax of 50% doubles work effort rather than reducing it.

This is, of course, a special case and it is possible in the more general
framework for the opposite to happen, i.e. for a reduction in the take-home wage to reduce effort, though as noted above the evidence is
against the trickle-down story. But this does show clearly that the claim that
higher taxes will reduce effort is not necessarily correct. If there is a strong
incentive to recover income losses after an increase in the tax rate, effort
will increase in contradiction to the trickle-down claims.

There is a huge and growing dichotomy in wealth between China's urban and rural areas. This dichotomy is growing as urban wealth rises faster than rural wealth. Reducing this gap means either increasing rural wealth or slowing down urban wealth. The fo... [Read More]

Tracked on Monday, May 14, 2007 at 11:33 PM

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Robert Frank: Trickle-Down Theories Don’t Hold Up

Speaking of
supply-side economics and trickle-down, Robert Frank explains that
trickle-down theory, which says that higher taxes on the wealthy will reduce
incentives causing lower growth and hence lower employment and income generally,
"is supported neither by theory nor evidence." Thus, contrary to what its proponents argue, trickle-down theory does not provide a valid
objection to a more progressive tax code:

Providing universal coverage will be expensive. With the median wage,
adjusted for inflation, lower now than in 1980, most middle-class families
cannot afford additional taxes. In contrast, the top tenth of 1 percent of
earners today make about four times as much as in 1980, while those higher up
have enjoyed even larger gains. ... In short, top earners are where the money
is. Universal health coverage cannot happen unless they pay higher taxes.

Trickle-down theorists are quick to object that higher taxes would cause top
earners to work less and take fewer risks, thereby stifling economic growth. ...
On close examination, however, this claim is supported neither by economic
theory nor by empirical evidence.

The surface plausibility of trickle-down theory owes much to the fact that it
appears to follow from the ... belief that people respond to incentives. Because
higher taxes on top earners reduce the reward for effort, it seems reasonable
that they would induce people to work less... As every economics textbook makes
clear, however, a decline in after-tax wages also exerts a second, opposing
effect. By making people feel poorer, it provides them with an incentive to
recoup their income loss by working harder than before. Economic theory says
nothing about which of these offsetting effects may dominate.

If economic theory is unkind to trickle-down proponents, the lessons of
experience are downright brutal. If lower real wages induce people to work
shorter hours, then the opposite should be true when real wages increase.
According to trickle-down theory, then, the cumulative effect of the last
century’s sharp rise in real wages should have been a significant increase in
hours worked. In fact, however, the workweek is much shorter now than in 1900.

Trickle-down theory also predicts a positive correlation between inequality
and economic growth, the idea being that income disparities strengthen
motivation to get ahead. Yet ... researchers ... find a negative correlation. In
the decades immediately after World War II, for example, income inequality was
low by historical standards, yet growth rates in most industrial countries were
extremely high. In contrast, growth rates have been only about half as large in
the years since 1973, a period in which inequality has been steadily rising.

The same pattern has been observed in cross-national data. ... Again and
again, the observed pattern is the opposite of the one predicted by trickle-down
theory.

The trickle-down theorist’s view of the world ... bears little resemblance to
reality. In the 1950s, American executives earned far lower salaries and faced
substantially higher marginal tax rates... Yet most of them competed
energetically for higher rungs on the corporate ladder. The claim that slightly
higher tax rates would cause today’s executives to abandon that quest is simply
not credible.

In the United States, trickle-down theory’s insistence that a more
progressive tax structure would compromise economic growth has long blocked
attempts to provide valued public services. Thus, although every other
industrial country provides universal health coverage, trickle-down theorists
insist that the wealthiest country on earth cannot afford to do so. Elizabeth
Edwards faces her battle with cancer with the full support of the world’s most
advanced medical system, yet millions of other Americans face similar battles
without even minimal access to that system.

Low- and middle-income families are not the only ones who have been harmed by
our inability to provide valued public services. For example, rich and poor
alike would benefit from an expansion of the Energy Department’s program to
secure stockpiles of nuclear materials that remain poorly guarded in the former
Soviet Union. Instead, the Bush administration has cut this program, even as
terrorists actively seek to acquire nuclear weaponry.

The rich are where the money is. Many top earners would willingly pay higher
taxes for public services that promise high value. Yet trickle-down theory,
which is supported neither by theory nor evidence, continues to stand in the
way. This theory is ripe for abandonment.

Here's a simple way to show that a an increase in taxes does not necessarily
reduce effort. Suppose you have a summer job and you have to earn $2,000 for the
summer. You don't need to earn any more than that, and don't plan to, but it is
a necessity that you reach this goal. Also suppose that you have a job paying
$10 per hour so that you can earn the money in 200 hours, or five 40 hour weeks. Let
taxes be zero initially.

Now let the government tax you at 50%, surely enough to reduce effort. But in
this case it won't. Instead, you will now work twice as long, 10 weeks or 400
hours at $5 per hour, in order to reach your goal of $2,000. So in this example,
a tax of 50% doubles work effort rather than reducing it.

This is, of course, a special case and it is possible in the more general
framework for the opposite to happen, i.e. for a reduction in the take-home wage to reduce effort, though as noted above the evidence is
against the trickle-down story. But this does show clearly that the claim that
higher taxes will reduce effort is not necessarily correct. If there is a strong
incentive to recover income losses after an increase in the tax rate, effort
will increase in contradiction to the trickle-down claims.